When Barclays issued £1.25bn (€1.5bn) in mandatory convertible notes to Middle Eastern investors in October, equity-linked teams started to field unusual calls from conventional equity and fixed-income investors wanting to learn more about the convertible bonds market.

Although MCNs are not strictly comparable with convertible bonds, the fact they generated more interest for the market can only be good news, given the decline in activity by hedge funds after the poor performance of most convertible arbitrage strategies this year.

However, there is a question over the extent to which this interest, which is coming from fixed-income, equity and private equity funds will convert into demand.

The 23% collapse in the UBS European Convertible Bond Index in September and October, driven by forced selling from convertible arbitrage funds and investment banks’ proprietary trading desks, gives a clear indication of the dominant role that these groups have played in the market.

After a brief fillip at the start of last month, the index fell to 131.9 points on November 24, 30% below the start of the year. Frank Heitmann, head of European convertible origination at Credit Suisse, said: “The depressed prices in the secondary market have attracted fixed-income investors who see an opportunity to get a cheap or free equity option on a convertible with a comparable spread to the companies’ straight debt.”

Similarly, equity investors can buy equity with downside protection at low or no cost. However, long-only investors need to feel more confident that the convertibles sell-off is over before they start buying.

There is also uncertainty about the commitment of these non-core investors. Makeem Asif, a director in European convertibles research at KBC Financial Products, said: “Fixed-income and equity investors will only stay in the market long enough to see bond values rise by five to 10 points before they sell. The market will not recover until hedge funds return.”

Monika Weiler, head of European equity-linked at JP Morgan, also believes that hedge funds hold the key to the convertibles market.

She said: “Some convertible arbitrage investors have gone from the market but there are certainly hedge funds that are still active in the secondary market and open for business.”

Fixed-income or equity funds that do decide to enter the convertible bonds market should be there for the longer term because of the investment needed to hire staff with convertibles expertise and to adapt internal systems, according to Weiler.

Despite the large numbers of convertible bonds trading at depressed prices in the secondary market, Weiler said there was demand for new issues because the value of the call option is higher.

She said: “The advantage of new issues versus the secondary market is that most existing convertibles are deeply out of the money and there is little chance they will convert.”

However, few European issuers are prepared to test the market. Exploration company Oilexeco had to cancel a $150m (€116m) convertible bond one day after it launched the deal. The issue failed even though the company raised the coupon on the bond from 12% to 15%, according to one analyst.

There have been only two convertible bonds issued since the start of August, but bankers believe the market will revive early next year. Laurent Morel, global head of equity capital markets at Société Générale Corporate & Investment Banking, said: “The convertibles market needs the right combination of sellers at current credit spreads and buyers of equity volatility before it will recover. Current activity in the straight corporate bond market is rather reassuring on the first point”

Issuers have already started to come to terms with wider bond spreads. Heitmann said: “Companies have realised that the bond market is not likely to improve in the next three months so they are starting to pay for term funding in size to refinance short-term debt despite the wider spreads.”

French energy group EDF issued a €2bn ($2.6bn) bond this month with a 5.6% coupon that matures in 2013, the largest euro-denominated corporate bond issued in a single tranche this year.

The next step will be finding investors prepared to buy equity volatility. This is part of the attraction of convertible bonds because volatility in the underlying stock makes the call option more valuable. Weiler said: “High volatility has been disruptive because it has affected all asset classes, even sovereign credit default swaps. Investors will not pay for today’s level of volatility.”

The CBOE Volatility index has been at an average value of 51.3 since the start of September, compared with 22.1 in the same period the previous year. Morel said: “Potential convertible issuers will profit from the rise in implied volatilities, but the extreme levels currently are unsustainable in the medium to long term.”